401(k) hardship distributions.

Distributions from 401(k) plans generally are not available until an employee reaches the age of 59 1/2, retires, dies, becomes disabled or separates from an employer's service. However, distributions can be made if the employee proves it is "necessary" to satisfy an "immediate and heavy financial need."

The Internal Revenue Service will allow such a distribution if it is for

1. Medical expenses of the employee or the employee's spouse or dependents.

2. Costs directly related to the purchase (excluding mortgage payments) of the employee's principal residence.

3. Tuition payment, room and board and related expenses for postsecondary education of the employee, spouse or dependent.

4. Payments necessary to prevent the eviction from a principal residence or to prevent foreclosure on the mortgage of a principal residence.

The determination of whether an employee has an immediate and heavy financial need is made on the basis of all relevant facts and circumstances. For example, the need to pay a family member's funeral expenses usually would qualify, but a distribution for the purchase of a boat or television ordinarily would not. A financial need may qualify even if it was reasonably foreseeable or voluntarily incurred. In other words, it does not have to be sudden, unusual or unexpected.

A distribution is considered necessary" if it satisfies the following requirements:

1. It does not exceed the financial need, including amounts necessary to pay resulting federal, state or local income taxes or penalties.

2. The employee obtained all distributions, other than the hardship distributions, and nontaxable loans available under all plans maintained by the employer.

3. The employee's contributions to the plan (and other employer plans) are prohibited for at least 12 months after the receipt of the hardship distribution.

If these requirements are not satisfied, a distribution still may be considered "necessary" if the need cannot be satisfied from other assets of the employee, spouse or dependents. However, property held for an employee's child under an irrevocable trust or under the Uniform Gifts to Minors Act is not treated as an available asset of the employee. The employee must certify in writing that the financial need cannot be met by

1. Insurance payments.

2. Liquidating assets (without causing a financial hardship).

3. Ceasing plan contributions.

4. Other distributions or nontaxable loans from plans maintained by the employer.

5. Borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need.

Finally, once a payment is deemed to be a hardship distribution, the amount distributed is limited to the employee's total plan contributions (excluding income earned on such contributions) as of the distribution date.

Observation: Hardship distributions generally are taxable when received, and since they are considered an early distribution from a qualified retirement plan, they also may be subject to an additional 10% excise tax under Internal Revenue Code section 72(t) if the employee has not yet reached age 59 1/2.

- Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island.